15 Chapter Understanding Accounting and Financial Statements http://www.wileybusinessupdates.com

Learning Goals Explain the functions and identify the three basic activities involving accounting. Describe the roles played by public, management, government, and not-for- profit accountants. Identify the foundations of the accounting system, including GAAP and the role of the Financial Accounting Standards Board (FASB). Outline the steps in the accounting cycle, and define double-entry bookkeeping and the accounting equation. Explain the functions and major components of the four principal financial statements: the balance sheet, the income statement, the statement of owner’s equity, and the statement of cash flows. Discuss how financial ratios are used to analyze a company’s financial strengths and weaknesses. Describe the role of budgets in a business. Outline accounting issues facing global business and the move toward one set of worldwide accounting rules. 1 5 2 6 3 7 4 8

Accounting Accounting is the process of measuring, interpreting, and communicating financial information to enable people inside and outside the firm to make informed decisions. People both inside and outside of the organization rely on accounting information to help them make business decisions. Lecture Enhancer: How might managers use accounting information to help control daily operations?

Open Book Management Open book management- sharing sensitive financial information with employees and teaching them how to understand and use financial statements. Viewing financial information may help them better understand how their work contributes to the company’s success. Outsiders use financial data to evaluate investment opportunities. To help employees understand the bottom line, many companies share sensitive financial information with their employees and teach them how to understand and use financial statements. Open book management supports that; allowing employees to view financial information helps them better understand how their work contributes to the company’s success. Lecture Enhancer: What are some possible drawbacks to practicing open book management?

Business Activities Involving Accounting Financing activities provide necessary funds to start a business and expand it after it begins operating. Investing activities provide valuable assets required to run a business. Operating activities focus on selling goods and services, but they also consider expenses as important elements of sound financial management. The natural progression of business begins with financing. Investing leads to operating. All organizations perform these three basic activities. Class Activity: Ask students how accounting supports a company's investing activities.

Accounting Professionals Public Accountants Provide accounting services (auditing, tax preparation, consulting) to individuals or business firms for a fee CPA Management Accountants Provide timely, relevant, accurate, and concise information that executives can use to operate their firms CMA Government and Not-for-Profit Accountants Public accountants provide services for individuals or firms for a fee. Certified public accountants (CPAs) demonstrate their accounting knowledge by meeting state requirements. Some management accountants achieve a certified management accountant (CMA) designation through experience and passing a comprehensive examination. Management accountants are focused on information for decision making. Government and not-for-profit accountants work somewhat the same as management accountants. They are focused on the efficiency of the organization. Lecture Enhancer: Compare and contrast the role of a management accountant with the role of a public accountant. 

Foundation of Accounting Systems Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time. Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S. Sarbanes-Oxley Act (SOX) responded to cases of accounting fraud. Created the Public Accounting Oversight Board, which sets audit standards and investigates and sanctions accounting firms that certify the books of publicly traded firms. Senior executives must personally certify that the financial information reported by the company is correct. Resulted in increase in demand for accountants. Click GAAP and FASB to access these organizations’ sites. To provide reliable, consistent, and unbiased information to decision makers, accountants follow guidelines. The FASB evaluates and monitors GAAP. Sarbanes-Oxley are new sets of regulations in response to cases of accounting fraud.

The Accounting Cycle Accounting cycle- set of activities involved in converting information about transactions into financial statements. The accounting process deals with financial transactions between a firm and its employees, customers, suppliers, and owners; bankers and various government agencies. The procedure by which accountants convert data about individual transactions to financial statements is called the accounting cycle.

The Accounting Equation Assets- anything of value owned or leased by a business. Liability- claim against a firm’s assets by a creditor. Owner’s equity- all claims of the proprietor, partners, or stockholders against the assets of a firm, equal to the excess of assets over liabilities. Basic accounting equation- relationship that states assets equal liabilities plus owners’ equity. Double-entry bookkeeping- process by which accounting transactions are entered; each individual transaction always has an offsetting transaction. The accounting equation involves assets, liabilities, and owner’s equity. It illustrates double-entry bookkeeping.

Impact of Technology on Accounting Simplifies the accounting process by automating data entry and calculations. Available products are customized for businesses of different sizes. Entrepreneurs and small businesses use: QuickBooks, Peachtree, and BusinessWorks. Larger firms use larger scale software packages like: Computer Associates, Oracle, and SAP. Software that handles accounting information for international businesses is another option. Offers different country information/language. Some systems offer web-based packages for small and medium businesses. Click the company names to view the websites of the software companies. Computers have streamlined the accounting process from manual bookkeeping and ledger entries. Computers have made accounting easier and faster. Web software packages allow users to access their complete accounting systems from anywhere using a standard browser.

Balance Sheet Balance sheet— statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time Photograph of firm’s assets together with its liabilities and owner’s equity Follows the accounting equation Financial statements provide managers with information for evaluating the organization’s ability to meet current obligations and needs, its profitability, and its overall financial health. The balance sheet is the first of these statements. Lecture Enhancer: What does the balance sheet tell about the status of a firm? What does a balance sheet not tell about a firm?

Sample Balance Sheet The sample balance sheet shows three classifications of assets, liabilities, and owner’s equity.

Income Statement Income Statement— financial record of a company’s revenues and expenses and profits over a period of time Firm’s financial performance in terms of revenues, expenses, and profits over a given time period Reports profit or loss Focus on revenues and costs associated with revenues Whereas the balance sheet is a snapshot, the income statement is more like a video. Income statements maintain the information to calculate financial ratios. Class Activity: Which industries generally have the highest net income? Lowest?

Sample Income Statement Income statements are sometimes called profit-and-loss statements. A key number to focus on is the bottom line. Keeping costs under control is an important part of running a business, and many managers push for revenues without managing costs.

Statement of Owners’ Equity Statement of Owners’ Equity— is designed to show the components of the change in equity from the end of one fiscal year to the end of the next Begins with the amount of equity shown on the balance sheet Net income is added, and cash dividends paid to owners are subtracted All of the additions and subtractions on the statement equal the change in owners’ equity. The new owner’s equity is reported on the balance sheet for the current year.

Sample Statement of Owners’ Equity The statement of owners’ equity uses information from both the balance sheet and income statement.

Statement of Cash Flows Statement of cash flows— a firm’s cash receipts and cash payments that presents information on its sources and uses of cash Accrual accounting— method that records revenue and expenses when they occur, not necessarily when cash actually changes hands The statement of cash flows shows the sources and uses of cash during a period of time. This report is important; inadequate cash flow is a reason for many business failures.

Sample Statement of Cash Flows The statement of cash flows shows the relevant information about a firm’s cash receipts and cash payments from operations, investments, and financing during a specific accounting period.

Financial Ratios Analysis Ratio analysis— tool for measuring a firm’s liquidity, profitability, and reliance on debt financing as well as the effectiveness of management’s resource utilization Financial ratios help managers interpret statements by comparing data about the firm’s current activities. Financial ratios are one of the most common tools used to measure the firm’s liquidity, profitability, and reliance on debt financing.

Liquidity Ratios Total current assets Current ratio compares current assets to current liabilities. Total current liabilities Cash and equivalents + short-term investments + accounts receivable Acid-test (or quick) ratio measures the ability of a firm to meet its debt payments on short notice. Liquidity ratios measure a firm’s ability to meet its short-term obligations. The current ratio shows that Diane’s Java has $2.58 of current assets for every $1.00 of current liabilities. A current ratio of 2 to 1 is satisfactory. Diane’s Java acid ratio is 1.5 to 1, Diane’s Java appears to have a strong level of liquidity. Ratios should be compared across periods and with other firms in the industry. Total current liabilities

Activity Ratios Net sales Inventory turnover ratio indicates the number of times merchandise moves through a business. Average of inventory Net sales Total asset turnover ratio indicates how much in sales each dollar invested in assets generates. Activity ratios measure the effectiveness of management’s use of the firm’s resources. Inventory turnover rates can vary widely from industry to industry. Higher total asset turnover ratios indicate greater efficiency. The inventory ratio of 5.13 shows efficiency compared to the industry standard. Kroger has an industry standard of 11.4, and Nike has a turnover of 4.5. Inventory turnover can vary depending on the type of products. The asset turnover of 2.15 is average compared to the ratio of 3.5 at Costco. Average of total assets

Profitability Ratios Profitability ratios measure the organization’s overall financial performance by evaluating its ability to generate revenues in excess of operating costs and other expenses. Profitability ratios measure the organization’s overall financial performance by evaluating its ability to generate revenues in excess of operating costs and other expenses. All of these ratios indicate positive evaluations of the current operations. Net profit indicates the firm’s profit. Net profit margins average around 5%.

Leverage Ratios Leverage ratios measure the extent to which a firm relies on debt financing. If management has assumed too much debt in financing the firm’s operations, problems may arise in meeting future interest payments and repaying outstanding loans. Total liabilities to total assets ratio > 50 percent indicates that a firm is relying more on borrowed money than owners’ equity.

Budgets Budget- planning and control tool that reflects a firm’s expected sales revenues, operating expenses, and cash receipts and outlays Management estimates of expected sales, cash inflows and outflows, and costs Budgets are a financial blueprint that serves as a financial plan Cash budget- tracks the firm’s cash inflows and outflows. Technology has improved the efficiency of the budgeting process. The cash budget is one of the most important budgets prepared by a firm. Lecture Enhancer: What are some items that you could include in your personal budget?

Sample Budget Because the accounting department is an organization’s financial nerve center, it provides much of the data for budget development.

International Accounting Accounting procedures and practices must be adapted to accommodate an international business environment. The International Accounting Standards Committee (IASC) was established in 1973 to promote worldwide consistency in financial reporting practices. The IASC soon developed its first set of accounting standards and interpretations and, in 2001, became the International Accounting Standards Board (IASB). International Financial Reporting Standards (IFRS) are the standards and interpretations adopted by the IASB. Exchange rates- ratio at which a country’s currency can be exchanged for other currencies Consolidated financial statements must reflect gains and losses due to changes in exchange rates Can have significant impact on financial statement Accounting procedures and practices must be adapted to accommodate an international business environment. As market economies in countries have developed, the demand for accountants has increased. Class Activity: How could a decrease in the exchange rate of the US dollar relative to the Euro be positive for the export business of an American company?